I am struggling to understand the answer to this question (the answer was given as C):

If inflation in South Africa is lower than that in the United States (US), US exports are becoming relatively _____ in South African markets. This shifts the demand curve for US dollars to the _______ and the supply curve of US dollars to the ________.

A. cheaper, left, right

B. more expensive, right, left

C. cheaper, right, left

D. more expensive, left, right

E. cheaper, left, left

I selected B. Firstly, I think that if you have to pay more for US exports because of inflation, they are more expensive compared to before. Secondly, using the equation E = RER x P*/P (where E is the exchange rate, RER stands for 'real exchange rate', P* is the foreign level of prices, and P is the domestic level of prices) I think that the rand depreciates and the dollar appreciates, which implies that the demand for dollars increased (presumably because more dollars are needed to pay the higher price), and the supply of dollars decreased (presumably because traders see that they should hold on to dollars until a later date, given the appreciation caused by increased demand).

1 Answer
1

During an inflationary period the value of the US Dollar has not increased, but decreased. From within the US, goods are becoming more expensive because each US Dollar is worth less.

Inflation is believed to be caused by an oversupply of money; if there is an oversupply of US Dollars, it will lead to a decrease in its value. If inflation is increasing at a higher rate in the US than in South Africa, the Dollar will be relatively cheaper, making it more desirable. Thus, an increase in the demand for the US Dollar, and a decrease in its supply.

$\begingroup$Would you go with C? You say that goods are becoming more expensive within the US - does that mean that US goods will become more expensive outside the US? I think that that depends on the exchange rate. If the exchange rate reacts completely to the change in price levels, the price of the goods in ZAR will not change. Am I correct? If so, there is a problem with the choice of answers.$\endgroup$
– ahornMay 20 '15 at 7:12

$\begingroup$It's not that goods are worth more, but that the dollar itself is worth less. Therefore, to purchase the same item, more dollars are needed. Similarly, more dollars would be needed to purchase a ZAR.$\endgroup$
– NoxMay 20 '15 at 17:13